Valuation strain encourages focus on quality, in the main

Our portfolio positioning in recent
months is decidedly more cautious. Cash holdings are elevated so that we are
ready to snap up bargains in risk assets as market volatility provides
opportunities.

Interest rates have dropped this year
as stalling economies and heightened uncertainties encouraged central banks to
return to more accommodation. Bond yields declined as the more pessimistic
outlook encouraged a flight to safety and equity markets rallied through higher
multiples despite softer earnings.

Together these forces encourage us to
be slightly underweight equities and property where only limited value is on
offer. We are modestly underweight US and Australian equities which offer least
value, neutral Europe where economic performance may surprise on the upside and
overweight Japan which is being largely overlooked by international investors.
Equities can continue to advance in the next several years, but we continue to
increase quality diversification and value in our portfolios at every
opportunity.

We are wary that more investors are
taking on even greater risk to achieve a targeted return by chasing
higher-yielding stocks or lower-rated credit at higher valuations. The poor
performance of recent initial public offerings such as Uber and Lyft and the
pulling of WeWork, Latitude Financial and PropertyGuru IPOs may be a sign that
the market is becoming more concerned about paying high multiples for growth
businesses.

The
valuation discrepancy between “growth” companies delivering sustained earnings
growth and “value” stocks that have more cyclical earnings profiles has become
even more stark in recent months. There is a high prevalence of companies in
information technology or healthcare sectors trading on earnings multiples of
30 times or more. By contract, several names in energy, financials and
materials trade on multiples in the 12 to 15 times range.

Heightened
concerns over the possibility of recession have encouraged a flood of money
into so-called “defensive” areas like consumer staples and utilities. However,
their lofty valuations mean they may not be defensive investments at all. In
time they may perform relatively poorly.

Our
preference for high quality results in a natural inclination toward “growth”.
However, there are several “value” names in which we have taken positions
because of the enticing prospective returns left on offer by a short-term
focused and overly pessimistic market. Some of these are more exposed to
cyclical forces than other companies we own, and their share prices are more
volatile as a result. However, each is well placed in its industry for longer
term success and offer compelling prospective returns for patient investors
like us. Their share prices should perform well if the
markets start to reduce expectations for a near term recession and if bond
yields continue to rise.

As wages continue their upward
momentum, prices in general will start to rise, bond yields will rise and
central banks in the US and Australia will be forced to shift to a tightening
stance. We are underweight the fixed interest asset class and our exposures
have shorter duration (or interest rates sensitivity) than the
benchmark. Given our focus on capital preservation, the bulk
of portfolio holdings are in government securities. We hold only
small exposure to corporate bonds, much of
which is hedged by longer duration government bond positions.

Manufacturing weak. Consumption solid

Global economic growth has hit a
significant downdraft which is likely to worsen during the remainder of the
year. Trade and geopolitical conflicts have raised uncertainties while demand
is being weighed by structural factors like low productivity growth, tightening
labour markets and aging advanced-economy populations.

Weakness in manufacturing and business
investment have started to weigh on services activity which until now has been
solid. Declines in business and consumer confidence point to a period of
constrained spending. Automotive activity has been particularly weak due to new
emissions standards in Europe and China and tighter industry lending practices.

The Conference Board’s Leading
Economic Indicators Index, which is intended to provide early signals of
turning points in economic cycles, has continued its downward trend since
mid-2018. The weakening environment makes corporate earnings growth harder to
achieve and there is downside risk to earnings expectations particularly if
trade conflicts worsen.

CHART 1: LEADING INDICATORS

Source: Conference Board

Despite prevailing challenges however,
activity should stabilise through next year on further employment and wages
gains which will encourage services activity. Recent monetary accommodation
will support interest rate sensitive sectors. Investment should steady through
2020 so long as trade tensions do not worsen.

United States activity is being helped
by solid consumption, improving housing and steady car sales. Europe has been
hit hard by weak export demand and Brexit distractions, but domestic demand
remains solid and there are early shifts toward increased fiscal support.
Japan’s growth is likely to be even slower as new fiscal action helps offset
the impact of the increased consumption tax.

China growth remains above that of
much of the world, although it is slowing due to trade friction, efforts to
contain debt expansion and the shift to consumption-led growth. Monetary and
fiscal policies have been expanded to help lift consumption, property
construction and infrastructure spend to offset weakened exports and private
investment. GDP growth should improve modestly in the December 2019 quarter
though we expect official China GDP growth to slip below 6% next year.

While we expect global growth to
continue through next year, protectionist policies could make it a bumpy ride.
There could be a sharper deterioration in conditions if corporates respond to
the increased uncertainties by reducing spending on capital equipment and jobs.
However, escalation of the conflict is unlikely ahead of 2020 US presidential
elections. Both sides would benefit from an easing in tensions – Mr Trump to
improve re-election prospects, China to improve growth prospects.

A complete rollback of the recent
tariff increases probably requires agreement from China to undertake
significant structural reforms. This appears unlikely at least in the short
term. Highly contentious issues remain including in relation to intellectual
property law and technology transfers. There are also several other sources of
tension not directly related to trade that make the achievement of a
substantial US/China deal appear a long way off, such as alleged currency
manipulation, 5G network development, Hong Kong unrest and questions over human
rights violations.

Return to monetary stimulus supportive
now but increases longer term vulnerabilities

Central bank easing in recent months
despite low unemployment, wages growth and reasonable economic expansion,
should help extend the cycle through next year.

The US Federal Reserve made a
significant about-face in policy this year. After several years progressively
tightening financial conditions, the Fed has shifted to more accommodation. The
federal funds rate has been cut by 25 basis points each in August, September
and October, to the current range 1.50% to 1.75%. At least one or two of these
cuts are likely to be proven unnecessary and leave less ammunition to fight the
next downturn. Unemployment is 3.6%, GDP growth is solid, and inflation is
close to the 2% target. Core PCE inflation is 1.8%.

The Fed’s moves have encouraged other
central banks around the world to also ease policy and this has prompted
further appreciation of the US dollar.

US Federal Reserve committee members
have been ignoring incoming economic data, concerned more with possible
downsides from trade negotiations, Brexit and financial markets volatility. The
first two of these are beginning to subside but financial markets turbulence
could well increase in the coming year.

The US Federal Reserve appears to be
shifting back to a data-dependent approach. A further 25 basis point cut early
next year is possible, but only if the US economy starts slowing more than
expected. Greater challenges lie ahead for committee members through next year
as inflation drifts above the 2% target, helped by wage increases, new tariff
costs and base effects of comparisons to soft prior year numbers. Bond yields
are likely to steadily increase which will be unsettling for equity markets.

Concerns about the downsides of very low interest rates are justified. Many savers are trying to fund their long-term spending plans, such as in their retirement years. Given aging populations and ultra-low interest rates, more people need to save even more money rather than consume. Negative or extremely low interest rates also encourage increased risk-taking by investors seeking targeted returns. Financial vulnerabilities are increased.

Andrew Doherty. AssureInvest

This article is provided as general information only and should not be construed as personal financial advice.

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The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by AssureInvest and therefore is not guaranteed to be complete or accurate, and AssureInvest accepts no liability for errors or omissions.

The Information constitutes only general advice. In preparing this document, AssureInvest did not take into account your particular goals and objectives, anticipated resources, current situation or attitudes. Before making any investment decisions you should review the product disclosure document of the relevant product and consult a securities adviser. Past performance is no guarantee of future performance. This document is not intended for publication outside of Australia.

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